How much of an activity's outcome is attributed to luck versus skill?
Was your favorable outcome because you are lucky or is it because you are skilled? What part of an activity requires skill and what part of it is due to luck? Most activities like sports, business, and investing require both skill and luck. Though some outcomes of activities are dependent more on luck than skill and vice versa.
In 2006, a number of Playboy chicks picked stocks at the beginning of the year. While the majority of the chicks under-performed the S&P 500 at the end of the year, their average gains of 8.6%, was still better than most professionally managed mutual funds. How does this happen? How can novices beat professionals at their own game? This suggests that luck plays a bigger factor in investing than skill - at least in the short run.
Michael Mauboussin, author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, explains in his book that in order to evaluate the true value of skill, in activities where outcomes depend more on luck than skill, more instances or sample sizes are needed. The reason is because over time that luck factor will neutralize and what you will be able to evaluate is the skill itself. This explains why terrible teams can go on multiple game winning streaks. But at the end of the season, they are at the bottom of the league rankings. But because there is more luck involved in the outcome of investing than in sports, we require a larger data set to evaluate the true skill in investing. While in most professional sports success is measured after each season, in investing most use the rule of three years.
The best way to ensure satisfactory long-term results is to constantly improve skill, which often means enhancing a process. Gaining skill requires deliberate practice, which has a very specific meaning: it includes actions designed to improve performance, has repeatable tasks, incorporates high-quality feedback, and is not much fun. Deliberate practice works well in domains that are dominated by skill—learning to play the cello, for instance." - Michael Mauboussin
However, with investing where much of your short-term results can be attributed to luck versus skill, it is difficult to get meaningful feedback. You can randomly pick stocks and in a roaring bullish market, the majority of them will go up in value. But this doesn't necessarily mean that you are a savvy investor or accurate predictor of the stock market. Without a proper trading plan, in the long-run your luck will run out and those gains will be taken away just as easily as they came. Therefore becomes more important is the process in which you selected stocks and how you manage your positions.
"And make no mistake about it: the reason to emphasize process is that a good process provides the best chance for agreeable long-term outcomes." - Michael Mauboussin
Labels: Life Lessons